May 2024
Tom Clendon explains the difference between a subsidiary and an associate – it’s all about control.
Question
What’s the difference between a subsidiary and an associate?
Tom’s answer
Understanding the difference between a subsidiary and associate is important. You need to know how they are each accounted for in the groups accounts, but also to be able to apply their definitions in classifying investments.
Define the terms!
A subsidiary is an entity controlled by another entity, known as the parent company. Control means having the power to direct the operating and financial activities, having exposure to variable returns by owning shares in the company and having the ability to exercise that power. Control is normally evidenced by the parent holding a majority of the shares.
An associate undertaking is an entity over which the investor has significant influence but not control. Significant influence is presumed when the investor holds in excess of 20% of the equity but not a majority. Good evidence of significant influence is having board representation. It is important to note that the definition of a subsidiary and an associate is not strictly speaking a numerical one. What matters is whether there is control or significant influence. And this can be a matter of judgement.
Accounting
Subsidiaries are aggregated with the parent company’s financial statements using acquisition accounting to produce the group accounts. Goodwill will arise. All assets, liabilities, income, and expenses of the subsidiary are combined with those of the parent company to form the group accounts. To the extent that the parent does not hold all the equity of the subsidiary then a non- controlling interest is recognised.
The rationale behind the full consolidation of the subsidiary is stewardship. Group accounts ensure that there is a reporting on assets and liabilities that are under a single control and the performance that those net assets generate. Through consolidation, the parent company effectively presents itself and its subsidiaries as a single economic entity. This reflects the economic reality.
Associate undertakings are accounted for using the equity method. Under this method, the investor initially records the investment in the associate at cost and subsequently adjusts it to reflect its share of the associate’s profits or losses and any distributions received.
Consider
Kirk owns 40% of the equity of Spock. The other shareholders of Spock are owned by a large number of investors who are not connected and each own less than 1%. There are three directors of Spock and two of these were nominated by Kirk. The issue is whether Spock should be classified and accounted for an associate or a subsidiary in the Kirk group accounts.
There is a rebuttable assumption that a 40% holding would give significant influence and therefore associate status. However, when the size and the dispersion of the other shareholders are considered together with the composition of the board the correct conclusion is that Kirk controls Spock. Spock is therefore a subsidiary of the Kirk group and should be fully consolidated using acquisition accounting. The NCI will be 60%.
Strange but true!
- Tom Clendon is an ACCA SBR online lecturer and podcaster who loves WhatsApp – 07725 350793
